Notes From Underground: Does Tapering Lead to a Narrow PEG of a Pant Leg?

Now that the FED has provided the U.S. and world financial system with a suit of liquidity, it is trying to figure out how to reduce the amount of material. The word “TAPER” is not my favorite for it fails to define what I believe is the goal of the FOMC. Who cares if the FED reduces it security purchases? That is not the problem. If the economy has any real traction the current balance sheet of more than $3 TRILLION should be quite sufficient to keep interest low. The dilemma is how to remove the LIQUIDITY without causing a collapse in Bernanke’s beloved PORTFOLIO BALANCE CHANNEL.

If the economy has real strength, the issue will be how to shrink the balance sheet without causing interest rates to rise dramatically. If the FED were to begin selling its Treasuries into the market, bond prices would fall and yields rise possibly undoing all the beneficial work of the QUANTITATIVE EASING programs. Downsizing the FED PURCHASES is just a statement that the FED believes the liquidity additions are no longer needed and tapering by itself should be deemed a positive for EQUITIES and the DOLLAR. THE CHALLENGE IS SHRINKING THE BALANCE SHEET WITHOUT PUTTING TREMENDOUS UPWARD PRESSURE ON INTEREST RATES.

There are many theories about how to go about reduction of FED assets: reverse repos, scheduled asset sales, raising interest on overnight reserves. Yet one plan keeps popping up: LETTING THE FED’S SECURITY PURCHASES ROLL OFF NATURALLY,meaning just hold them to duration so that the bonds are relinquished by calendar attrition. The FED has securities of many different durations so the roll off would be a gradual reining in of liquidity. The problem then becomes the issue of a massive monetary overhang gaining velocity as the economy improves. Monetary theorists have continually warned that is has been the low VELOCITY of MONEY that has kept growth down. (This is the money part of Richard Koo’s “Balance Sheet Recession”–if people are improving their balance sheets and paying down loans the money the FED puts through via QE fails to provide the needed boost to the economy.) When the economy gathers strength the more liquidity will be available for lending and thus the fear of rapidly rising inflation. THE FED IS AWARE OF THIS DILEMMA OF SPOOKING THE FRAGILE RECOVERY OR ALLOWING RAPID INFLATION.

After rereading the recent Jeremy Stein speech and reading other pieces, the FED seems to believe that it can control the inflationary effects of a roll off by instituting macro-prudential regulation. The FED can utilize liquidity regulation and capital requirements to control the velocity of its massive QE programs. By placing restrictions on type of bank assets that are needed for liquidity coverage ratios, the FED can significantly restrict the amount of credit available to the economy. Also, the FED can insist on higher capital requirements under the guise of TOO BIG TOO FAIL in order to prevent the large banks from over leveraging their balance sheets.

Severe credit rationing in the times of abundant liquidity may allow the FED to play for time and thus not unload its assets in a fire sale manner. The unknown is how this will negatively effect an economy addicted to credit and may well be the reason Pimco sticks to its views about the NEW NORMAL. Credit rationing by FED MACRO PRUDENTIAL REGULATION MAY WELL BE THE NEXT CHAPTER. Of course, what I propose is mere conjecture, which is why at Notes From Underground 2+2=5.

***Just a quick note on the recent activity in the yield curves. Since the “surprise” cut by the Reserve Bank of Australia, the Aussie curve has widened 24 basis points in a very short time. This is a positive for as I argued Aussie dollar strength was an effect of an overly tight monetary policy. The recent steepening has resulted in a 4% decline in the Aussie dollar. This was a successful interest rate cut to promote a policy of countering a slowing economy. The Japanese 2/10 has also begun to steepen and has widened out of its previous range. The Japanese curve will be more difficult to play on a day-to-day basis because of the massive amount of BOND buying by the BOJ. The Aussie stock market and the Japanese Nikkei index have both performed well as the central banks have eased policy. For the Aussie all ORDS , it may take another 75 basis points of cuts to get the equity market back to the highs of 2007-08.

***Bloomberg reported today that the Japanese money managers were net buyers of foreign bonds after purportedly cutting foreign bond holdings in the period of their fiscal year-end (March 31). For those G-7 members who say the Japanese are adhering to previous agreements about currency intervention because the BOJ is not buying foreign bonds this is of course technically correct but structurally wrong. If the BOJ is buying in all the JGBs (10-year Japanese bonds) then the sellers to the BOJ will have to replace those assets with other bonds or equities.

Japanese insurance companies have to fund annuity payments and will have to find “safe” foreign bonds to supplant the JGBS. So yes, the BOJ is just driving the get-away car. Also, I am linking to a piece from the BLOG, Observing Japan, written by my son Tobias Harris (not the basketball player), titled, ON ABENOMICS. Toby is a very valuable resource on all things Japan.

One problem I had with the “peg pant leg” of early 1960’s (cool dude, eh?) was that as a swimmer my calves were developed, but I was then (alas) slim waisted. Therefore if the legs rode up, they stuck and I had to manually push them down. In FED parlance, what I’m thinking is that they might have made the pant legs too narrow, or could, and therefore cut-off the circulation (liquidity). I needed 2 more years and a hitch in the military to rid myself of the “Peg”. This all presumes your “PEG” is referring to the spigot and not what something is being “pegged to”.

Jes, learnin’ boss. and you are providing some thought-provoking material.

Ron–dead right on target.And to Jim Sinclair–I certainly don’t disagree that the beginning of tapering will get a severe sell off in the equity markets but it won’t have the massive impact of actaully removing assets off the balance sheet.As we know,presently the FED not only increased it bond purchases it continues to buy all the “naturally expiring” paper with fresh assets—which is why the balance sheet continues to grow.

Tapering reminds me of pinching off a loaf. If the FED is able to off load the bankrupt Ninja MBS book to the Treasury do they beleive they can sell off the foreclosures to investors and then dump them during the midterms to the muppets with new NINja loans via freddie and fannie getting their boyo’s reelected before the next bust?

The Plan
The Fed should sell its MBS portfolio to the Treasury at face value in exchange for an actuarially equivalent amount of Treasury securities, newly issued for the purpose of facilitating the swap. The maturity of these new Treasury securities could be set either to match the expected maturity of the Fed’s MBS portfolio or to allow them to roll off at the same pace as the Fed expects it will wish to contract its balance sheet (each approach has its own technical merits). The transaction would be neutral for the size of the Fed’s balance sheet; only the composition would change.

$1.1T or 1/3 of the Fed balance sheet are MBS securities. When the Fed tapers off purchases of MBS the cashflow on the outstanding balance will reduce the Fed’s balance sheet by 1/3, slowly over time. Too slow, or just the right taper?

Brian–assuming that the taper is in the mbs –i think the point that david tepper made this morning on cnbc about the shrinking deficit causing problems means that the FED will taper in the the treasury market and not the MBS—housing is still fragile and it will give them cover to say the deficit is not as large as initially thought so there is room to cut treasury buying for the health of the credit markets

Yra – key questions:
Wouldn’t the fed wait to see structural improvement in the labor market before deciding to go ahead with said taper?

Secondly, an observation by Scott Ramsay in his interview in Schwager’s latest “HFMW”, was that QE was simply the Fed conducting a swap of non-interest bearing assets (cash) for interest bearing assets (bonds) with the private market. Do you agree?

In this case, perhaps this whole rally has been predicated on the inflationists’ perceptions that because there has been a material increase in the money supply therefore inflation will rise and equities should rally. In my mind, this does not pay enough credence to the diminishing returns demonstrated by the velocity of money.

Nonetheless, I guess I come to the same conclusion as Jim. If the Fed does taper, I expect a large correction in equity markets.

Carl–I think that point you raise by Scott Ramsay depends on how the FED decides to extricate itself–if the end is a natural roll off then I think that is dead right–if the fed actually sells off its book[SOMA] then i don’t agree–which is why I wrote the piece last night and you definitely caught.Again,CNBC is running wild with david Tepper’s view which is in line with my conjecture–but that makes me worry–although Tepper is an astute investor